Bankruptcy is the last resort for people who are completely unable to pay their debts. There are several types of bankruptcy, but almost all individual bankruptcies in the US fall into two categories: Chapter 7 and Chapter 13. There are important differences between these categories, and if you are considering bankruptcy you need to know which type is best for you.
- Chapter 7 bankruptcy is designed for people whose incomes are not sufficient to pay back their debts. Chapter 7 involves liquidation, meaning that most of your assets will be sold by a court-appointed trustee. The proceeds will be used to pay your creditors.
- Chapter 13 bankruptcy involves reorganization, not liquidation, and does not require the sale of assets. You will be given a court-mandated repayment plan, and if you complete the payments you may be able to keep your property.
What is Bankruptcy?
Bankruptcy is a legal process that is applied when an individual or business cannot pay back debts. Bankruptcies in the US are administered by US bankruptcy courts and governed by the US bankruptcy code. Bankruptcies often involve the appointment of a trustee, who oversees the bankruptcy process.
Bankruptcy usually requires some debts to be paid, either by liquidating assets or under a court-ordered repayment plan. Unsecured debts that the debtor cannot pay may be discharged, which means they no longer have to be paid.
Some forms of debt cannot be discharged in a bankruptcy. If you have any of these forms of debt, bankruptcy will not provide relief.
- Child Support
- Tax Arrears
- Student Loans (except in rare cases)
Almost all individual bankruptcies in the US fall into two categories: Chapter 7 and Chapter 13, named after the chapters in the bankruptcy code that lay out the rules that govern them.
What is Chapter 7 Bankruptcy?
Chapter 7 bankruptcy is designed for people who have little or no disposable income. To qualify for a Chapter 7 bankruptcy you must either:
- Demonstrate that your income is below the median income for your state, or
- Pass a means test to demonstrate that you don’t have enough income to pay your debts.
Filing for Chapter 7 bankruptcy can produce immediate relief from some debt collectors. Once you file your bankruptcy papers, some creditors may be unable to contact you, collect from you, continue wage garnishment, or pursue legal action against you.
A court-appointed trustee will supervise the liquidation of your assets. The proceeds from the sale of your assets will be used to pay your creditors. If you have no assets the creditors will not be paid.
Some assets or a portion of their value are exempt from liquidation. If an asset is fully exempt you will be allowed to keep it. If a portion of the value is exempt you will be allowed to retain a percentage of the proceeds from the sale of the asset.
When the liquidation is complete your remaining unsecured debts may be discharged. You will no longer be responsible for those debts and the creditors will no longer be able to seek payment.
In most cases, the bankruptcy court issues a discharge order for a Chapter 7 bankruptcy 60 to 90 days after the first meeting with creditors. The discharge order effectively closes the case. The process may take longer if a creditor files an objection to the discharge of a debt.
If the bankruptcy court determines that you have enough income to pay some of your debts your bankruptcy may be changed to a Chapter 13.
Advantages and Disadvantages of Chapter 7 Bankruptcy
Chapter 7 bankruptcy has several advantages for people with high debt loads and insufficient income:
- Immediate relief from debt collectors. Many debt collectors will be barred from contacting you or initiating action against you once you have filed your bankruptcy papers.
- Relatively rapid resolution. A Chapter 7 bankruptcy is usually resolved within 100 days. There’s no extended repayment plan period with your finances supervised by a trustee.
- Reduced monthly debt payments. You may emerge from a Chapter 7 bankruptcy with fewer assets, but you will also have fewer debts to pay. That means more free cash for food, shelter, and other basic necessities.
- A fresh start. A Chapter 7 bankruptcy can give overwhelmed debtors a fresh start. If you’ve learned from your experience you can begin building a better financial future free of much of your debt burden.
Chapter 7 bankruptcy also has disadvantages:
- Loss of assets. You may lose your home, car, or other possessions.
- Damaged credit. Bankruptcy can have a serious impact on your credit, and it may be some time before you can get a loan or a credit card.
- Creditors may challenge debt discharge. Creditors also have rights in a bankruptcy proceeding. If a creditor believes that you have the means to pay a debt they may object to its discharge, and the court may uphold the objection.
Chapter 7 bankruptcy is usually recommended for individuals with high debt, low incomes, and few or no assets.
What is Chapter 13 Bankruptcy?
Chapter 13 bankruptcy is designed for individuals who have enough income to pay all or some of their debts and those who have assets that they’d like to protect. If your income is above your state’s median and is sufficient to meet all or some of your obligations, you will be required to use Chapter 13.
Chapter 13 eligibility requirements include:
- Regular Income
- Total Unsecured Debts of Less Than $394,725
- Total Secured Debt Under $1,184,200
When you file for Chapter 13 bankruptcy the court will appoint a trustee to develop and supervise a repayment plan for your debts. The repayment plan will last for three to five years. During that time, you will make a single monthly payment to the trustee, who will distribute the payment to your creditors.
When the repayment plan period is complete your remaining unsecured debts may be discharged.
If you fail to make payments under your plan your bankruptcy case could be dismissed or converted to Chapter 7. You could lose assets and you could be open to collection efforts again.
Advantages and Disadvantages of Chapter 13 Bankruptcy
Chapter 13 bankruptcy has some advantages.
- You will be able to retain some assets. If you follow your repayment plan you will be able to keep your house, car, and other assets.
- Debt collections, foreclosures or repossessions may be stopped. When you file for bankruptcy these procedures may be frozen while the bankruptcy procedure is completed.
- The damage to your credit may not be as severe as the damage from a Chapter 7 bankruptcy would be.
Chapter 13 bankruptcy also has important disadvantages:
- Repayment plans require financial discipline for extended periods of time. You will essentially be pledging your disposable income to the trustee for the duration of the repayment plan.
- Failure to make your payments may cause dismissal or conversion to Chapter 7.
- Your credit will be affected. The impact may not be as great as that of a Chapter 7 bankruptcy, but a Chapter 13 bankruptcy will appear on your credit report and it can harm your credit.
Chapter 13 bankruptcy is recommended and sometimes required for debtors who have disposable income and have assets that they wish to retain.
Bankruptcy and Your Credit
Bankruptcy will have a serious impact on your credit, but by the time you apply for bankruptcy much of the damage has probably been done already. Your credit may not drop much more when you file.
- Chapter 7 bankruptcy will remain on your credit report for up to 10 years.
- Chapter 13 bankruptcy will remain on your credit report for up to 7 years.
You can still qualify for credit after a bankruptcy, but approval may be difficult and you may have to pay high fees and interest rates.
You will not be able to apply for a mortgage until a waiting period has passed.
- The waiting period for a mortgage after a Chapter 7 bankruptcy is 4 years, or 2 years if the bankruptcy was caused by circumstances beyond the borrower’s control.
- The waiting period for a mortgage after a Chapter 13 bankruptcy is 2 years after discharge or 4 years after dismissal, or 2 years after dismissal with extenuating circumstances.
The impact of bankruptcy on your credit will be reduced as time passes, especially if you establish a good financial track record after your bankruptcy.
How to File for Bankruptcy
Bankruptcy is a complex legal proceeding. If you are considering bankruptcy you should seek the assistance of a lawyer who specializes in bankruptcy. Your lawyer will help you decide which form of bankruptcy best fits your situation.
If you cannot afford a lawyer there are several options:
- Negotiate reduced attorney’s fees. If you can’t afford an attorney’s fee quote, offer what you can afford. The attorney may accept.
- Pay your fees through your Chapter 13 repayment plan. If you are filing for Chapter 13 bankruptcy you may be able to pay your attorney’s fees in installments as part of your repayment plan.
- Seek help from a free legal clinic or legal aid society. Many cities have free legal aid centers. Some law schools and some bankruptcy courts also have legal clinics to assist debtors who can’t afford attorney’s fees.
- Find a pro bono attorney. Some attorneys and law firms regularly take cases “pro bono”, or free of charge, or at reduced rates. You can ask your state or local bar association for help in locating a pro bono attorney. The American Bankruptcy Institute has a Pro Bono Attorney Locator.
- Represent yourself. It’s not necessary to have an attorney to file for bankruptcy, but it’s highly advisable. Mistakes or failure to understand complex laws and regulations could lead to the dismissal of your case. Complex bankruptcies in particular almost always require legal representation.
You will need to complete a set of bankruptcy documents and supply the court with information about yourself. The requirements are different for each type of bankruptcy.
If you are filing for a Chapter 7 bankruptcy you will have to prepare the following information.
- A list of your creditors and the amount and type of their claims.
- Your job, salary, and any other income you have.
- A list of all your property.
- A detailed list of your monthly living expenses.
- A certificate showing that you have been through credit counseling.
If you are filing for a Chapter 13 bankruptcy you will need to submit all the information required for Chapter 7 bankruptcy, along with your proposed repayment schedule. You will also need to provide your recent tax returns, and potentially other information as well.
You will file the bankruptcy papers at the US bankruptcy court with jurisdiction over your area.
The information you provide to the bankruptcy court must be accurate and complete. Providing false information or trying to conceal assets is illegal. Your case could be dismissed, and you could face criminal prosecution.
Creditors also have rights in the bankruptcy system, and they can challenge your filings. Debt obtained through fraudulent means can be exempted from discharge, and other debts can be ruled non-dischargeable as well.
Bankruptcy is Not the End
Bankruptcy may seem like the end of your financial life. It’s not. It’s intended to give you a fresh start. Most bankruptcy filers have better credit two to four years after filing for bankruptcy than they did before filing.
Nobody wants to file for bankruptcy. It’s the last resort for people with no other option. If you’re in that position, though, choosing the right form of bankruptcy for your circumstances can get your creditors off your back and let you start rebuilding your finances.